Today I’m going to talk about an
alternative to the insurance of shares when you’re raising capital for your
seed round. We’re going to talk about convertible
loans or convertible debt. What is this? Well, first of all you
should keep in mind that convertible debt is not equity. It sounds silly, but you shouldn’t confuse
the two of them, they are two very different types of securities. With equity or shares you are part of the shareholders. If you are a debt holder, as much as it is convertible, you are senior to the equity holders, meaning
that in case of a liquidation of the company for acquisition or for any other
reason. you they are going to get their money back
before the shareholders. That’s very important. But this is not it! Because they are not simply debt holders, they are debt holders with a special right to convert into shareholders, meaning
that they are protected from the downside because they have debt, so they are senior to the equity holders, but they can also join the upsides whenever the company
goes well, which sounds very very favorable if you
ask me. Convertible debt is a very
complicated security that can have very important and even drastic
implications on your cap table whenever they convert. So it’s very important for you as a
founder to understand exactly what’s going to happen and there are
some tools online that will help you with that. The convertible debt comes
with a few terms that you should absolutely read about. The first is the interest
rate so what is, on the amount that the investor invests, what is the interest rate that he’s
going to gain throughout the tenure of debt. The second aspect is the discount, meaning that whenever they convert,
they’re going to get the discount on that valuation so if a new investor comes in, let’s say a VC firm, and they buy into your valuation at 5 million pre-money, your
investors, your debt holders are going to convert not a 5 million
pre money, they are going to convert at 5 million minus the discount. That’s very important. Then there is
another very very tricky aspect, that is the cap. The cap is the maximum valuation that they can convert at. If an investor comes in and they value
the company of 5 million pre-money but you have a cap for 3 million pre
money, they’re going to convert at 3 million plus the discount. It is very important
because you may have your early stage investors or debt holders to convert at a very very favorable valuation, meaning that the original founders will actually
end up with much much less in the company. I also have to say that
some VC firms may be skeptical in investing in companies that issued convertible
debt in such an early stage. That depends a bit on the geography but it could be a problem in some cases, depending on the terms. So be careful with that, it can be a good way to raise your first capital but if
you think that you’re going to escape the problem of valuating your business
as such an early stage, that is not true. There is not a shortcut because any way
you are going to be required to put a cap, so you’re going to have a valuation
discussion anyway, because you should at least imagine what’s going to happen when the next round comes in, which means when they are going to convert from debt to
equity. Hope this helps you, you can try out our free convertible debt tool here
below in the description, and you can see what are common or averages for
discount averages, interest rate or for the cap on the company. Have fun with that, and I see you in the next video!